JPMorgan Deploys New Risk Model for Derivative Bet

JPMorgan Chase & Co. (JPM), whose trading
loss of more than $6.2 billion was fueled by the adoption of a
flawed mathematical formula that understated the risks, is
trying yet another one.

JPMorgan said today it started using a new formula to judge
the risk of the derivatives position, at least the third such
model it’s used this year, when it moved most of the contracts
to the investment-bank unit. The new analysis cut the firm’s
calculation of overall value-at-risk, or VaR, by $36 million, or
24 percent, to $115 million in the third quarter, the New York-
based bank said today on its website.

JPMorgan’s switch to a new risk model in January may have
helped fuel the trading loss at the chief investment office,
Chief Executive Officer Jamie Dimon told the Senate Banking
Committee in June. Dimon said May 10 that the bank had reviewed
the effectiveness of that VaR model, deemed it “inadequate”
and decided to return to the previous version. Restoring the use
of the earlier model meant the risk was twice what the bank had
reported in April.

“VaR models change almost every time we talk,” Dimon said
today in a call with journalists. “When we moved it to the
investment bank, they adopted, particularly for the synthetic
credit portfolio -- and there are some other changes too -- the
investment bank’s model, which we think was the best one.”

The January switch and the timing of the firm’s disclosures
are the focus of an inquiry by the Securities and Exchange
Commission as the U.S. examines how long executives knew about
the CIO’s swelling bets and losses. VaR is an internal estimate
of the maximum a portfolio could lose on 95 percent of days, or
the minimum it could lose on 5 percent of days.

‘More Frequent’

“These kinds of changes seem to be a little more frequent
than what I would normally be used to seeing,” said Cliff Rossi, a former chief risk officer for Citigroup Inc.’s Consumer
Lending Group. The Office of the Comptroller of the Currency
“will be wanting to take a much closer look at the validity and
the stability of that model and its underlying assumptions to
make sure that what they’ve got in there now is better than what
they had in the last two iterations.”

Bryan Hubbard, an OCC spokesman, didn’t immediately respond
to a request for comment.

The firm said today that the investment bank unit’s
position assumed from the CIO had a “modest” loss in the third
quarter. The CIO had a loss of about $449 million in the period
as it “effectively closed out” its position.

‘Still Unaware’

The model that was implemented in January “did effectively
increase the amount of risk this unit was able to take,” Dimon
told the Senate panel in June. On April 13, when he downplayed
the risks of trades on a call with analysts, “we were still
unaware that the model might have contributed to the problem,”
Dimon testified. “So when we found out later on, we went back
to the old model.”

Dimon told lawmakers in June that the models “never are
totally accurate in capturing changes in business,
concentration, liquidity or geopolitics.” JPMorgan uses data
going back one year, Dimon has said, so the VaR figure might
fall just because a volatile week was no longer included in the
calculation.

“This is all nonsense,” said Steve Allen, former head of
risk methodology for JPMorgan who retired in 2004. “Because we
know that the risk positions are illiquid, we know with
certainty that these numbers are irrelevant to the risk of the
position.”

‘Another Example’

JPMorgan has added a warning in its most recent quarterly
report that risk models are continually tweaked to account for
“improvements” in modeling techniques, and SEC Chairman Mary Schapiro has publicly asserted that banks should disclose
significant changes and the reasons.

“It’s another example of the fact that banks are very
opaque, they’ve always been opaque, they continue to be opaque,
and running around spending a lot of time analyzing changes in
the little bit of data that they give out is not really
contributing very much to the knowledge base of the world,”
Allen said.

While models must be kept up to date to reflect market
conditions, too many significant changes may destroy their
usefulness, said Rossi, who is now executive-in-residence at the
Robert H. Smith School of Business at the University of
Maryland.

“These are important benchmarks by which you’re setting
risk tolerance in your trading book,” said Rossi. “If things
are shifting around, it’s like having a compass that’s spinning
around because you can’t anchor it to something. That’s
problematic from my standpoint.”